Derivatives as a Way of Mitigating Financial Risk - Literature review Example

? Derivatives as a way of mitigating financial risk October 19 Introduction Derivative is a type of financial instrument and a contract drawn between two parties for certain assets that are subject to variables such as value of the assets, dates and notional amounts. These variables determine the payments that must be made for the parties. Assets that are used include stocks, commodities, bonds, currencies and interest rates. Common types of derivates available are swaps, futures, forwards and options. The instruments are given special legal exemptions so that they are used to obtain credit. Certain creditor protection rules are extended to these derivatives and this helps to increase their security and reduce financial risks. The other side is that with excessive credit protection norms, capital markets will under price the credit risks. This means that risks that should be valued at say 100 Pounds will be considered to be worth only 80 Pounds. This increases systemic risks and helps to propagate credit booms. The reason is that the lending firm considers a risk of 80 Pounds worthwhile while extending loans whereas if the assets had a risk of 100 Pounds, the lending firm would reduce the amount lent (Chance and Brooks, 2010). The paper will examine how derivatives based on standard assets and bonds can be used as a method of mitigating risk. 1.1. OTC and ETD and risk management Two main types of derivates are available and these are over the counter derivatives – OTC’ and ‘exchange traded derivative contracts’ - ETD. OTC instruments are privately traded between two parties and the exchange is not involved. Instruments traded included forward rate agreements, exotic options, swaps and other types. The main constituents and partners in the OTC markets are banks, financial institutions and hedge funds. The market is estimated to be worth 708 trillion USD and most of it occurs in private without any public listing and declaration. Out of this amount, 67% is for interest rate contracts, 9% are foreign exchange contacts while credit default risk make up 8% and ht rest is made up of equity contracts, commodity contracts and others. Since there is no external counterparty that acts as a central agency and mandates the exchange of contracts some, element of risks can exist. These risks can occur if either of the party cannot or will not honour its commitments to pay the contracted amount. This possibility is rare since banks and financial institutions are expected to be stable. Hence, derivatives are used to make the appropriate profits in ITC markets (BIS, 2011). In the case of exchange trade derivatives, these instruments traded through the derivatives exchange serve as an intermediary for the transactions. The exchange takes a certain percentage from both parties as the initial margin. The combined revenue of the world's derivatives exchanges was about 344 trillion USD. Examples of instruments that form ETD are futures contracts, interest rate and index products, convertible bonds, and warrants. These instruments can be traded only through special derivatives exchanges such as KOSPI Index Futures & Options, Eurex, Chicago Mercantile Exchange, New York Mercantile Exchange and others. These instruments have certain guaranteed prices on the maturity value and the guarantee is given by the derivatives exchange that has already taken a margin from both parties. This helps to manage risks. Due to low risks, returns obtained are also less and may range in the 3 to 6% range (Bartram, et all, 2011). The derivatives market and risks are different from the equity market where individuals can take up stock trading on their risk. The firm whose stocks are traded in the stock market will not give any assurance about the price stability or that a certain amount of dividend is payable. The stock market exchange also does not regulate the transactions between the parties. Therefore, if the price falls, the risk is borne by the party. In effect, derivatives markets transfer the risk from parties that aver risk to those who have an appetite for risk. Returns are however obtained on long-term prospects rather than short term as seen in the case for equity markets (Bartram, et al, 2009). 2. Manner in which derivatives can be used to mitigate risks In this section, the various types of risks faced by derivatives and the stock market are analysed and the manner in which derivatives can be used to mitigate these risks is discussed. Any stock faces these standard risks in the market. It will be seen how derivatives can be used to mitigate these risks. 2.2. Derivatives and risk types that can be mitigated Different types of risks that exist in the market are price risk, default risk, liquidity or funding risk, legal risk, settlement risk, operations risk and systematic risk. These risks are analysed and the manner in which derivatives can help to manage them are given as below (Jarrow and Turnbull, 1995). Price Risk: Price risk occurs when the actual futures price on the date of maturity is less than the contracted price. This risk is not applicable to derivatives because of two features. One is the absence of arbitrage where the price can be different from the contracted rate. The other is the fact that the rates are fixed price contracts and these provide sufficient hedge against the risks. Default Risk: This risk can occur when the counter party defaults. This risk is also called as credit risk, counterparty risk, legal risk, Herstatt risk and so on. Either party can default before the contract matures. This can happen when a party realises that it is unable to meet its obligations of future payments and may declare bankruptcy. This is an extreme step and while this risk exists, it does not happen often since the bankrupt party and the principal promoters are barred from further trading. No investor wants to risk such a punishment. Systemic risk: This is a widespread default in the derivatives market. Failure of one instrument can create a domino effect and cause the financial market to crash. This kind of a risk is possible but rare and it has happened during the great depression of the 1930s, the Asian market failure of 1997, the economic recession of 2207 and so on. Temporary disturbances will not impact existing derivatives if the maturity date is a few months away. Large shocks with effects lasting for a few years can hurt the derivatives and all other instruments. Agency Risk: This risk can occur when the agency that floats the contracts goes bankrupt. Examples are Barings bank, Lehman brothers and other such agencies. This risk can be avoided if strict controls are placed over errant managers taking high-risk positions and indulging in gambling. 2.2. Instruments that are used to mitigate risks Different types of derivative instruments can be used to reduce the risk. These include forward contracts and financial futures and they help to reduce the financial risk by using hedging. When a derivative is taken with a six months maturity, it means that the buyer has taken a 'long position'. There are certain benefits and risks since one does not know what the market six months down the line would be. When the same firm sells a contract to deliver a product at a future data, it has taken a short position. Hedging risk means to take a financial transaction that helps to offset a long position by taking up and additional short position or by offsetting a short position by taking an extra long position. This means that if the firm buys a product and has taken a long position, it can conduct a hedge by taking up another contract to sell the contract and take a short position at some future date. It can be other way also. This way, the risks are minimised for the product (Hentschel and Smith, 2008). Forward contracts are a type of agreement where the parties take up transactions at a future or forward point of time. These can be interest rate forward contracts and forward contracts for foreign currencies. Interest rate forward contracts are for future sale of debt instruments and they specify the debt instrument to be delivered, amount, price, interest rate, and date of delivery. Now suppose company A takes a long position where the interest rates would increase by 5% after five years. It should then enter into another contract with another party where the interest is at par after five years. In this manner, company A is hedged against interest rate failure. There would be a problem if another party that agrees to at par contract were not found (Booth and Smith, 2004). Foreign exchange risks are hedged by using forward financial futures contracts by banks and other institutions that trade in Forex currencies. Forex rates are highly volatile and variations of more than 10% in a year have occurred in the past decade. This can happen in the following way. Assume that company A is to receive 10 million Euros due in 2 months for assets of 10 million USD it has sold to company B in Germany. Company A wants to ensure that Euro does not depreciate excessively from the current value else, it will face a large loss since it must pay the equivalent of 10 million USD. Therefore, company A then hedges the foreign exchange by using forward and financial futures contracts. To do this, company A takes a long position in Euros and this is then offset by a short position of the same value at the current value of Euro for a period of two months. After two months, when Company A gets the 10 million Euros, the forward contract ensures that an exchange for USD at the contracted rate will be carried out. Therefore, the firm is guaranteed of 10 million USD for the goods sold in Germany for Company B (Walter, 1993). Thus, company A is protected from financial risk. 2.3. Risk types that cannot be mitigated with derivatives The previous section has discussed the various types of risks and the manner in which derivatives help to manage these risks. Derivatives can be used to manage risks to a certain extent. However, given the nature of the market, absolute guarantee that risks will be managed fully is not possible. A reasonable mitigation of risks is however possible (Chance and Brooks, 2010). This section presents the derivatives failure for crude oil price in 2008. Consider the price variations and futures for crude during 2007-2008. Crude oil price had shot up to 147 USD per barrel in July 2008. At this point, it was being predicted that crude oil price would cross 200 USD/ barrel and the futures for crude oil for six months maturity rose to 200 USD/ barrel and in some markets, it even crossed 250 USD/ barrel. This rise was caused by speculators who wanted to make the maximum profits and the speculation created a bubble. However, on 23 December 2008, crude prices collapsed to 30 USD/ barrel causing a huge shock in the market. Those who had purchased derivatives in July for six-month futures prices of 200-250 USD/ barrel suffered huge losses. Insurance firms that had underwritten the deals refused to honour the deals. The whole derivatives market for crude oil and other commodities underwent a sea change in the structure and composition and speculators were eased out. Stability returned to the market (Euromonitor, 2008). The point made is that derivatives cannot provide security and risk mitigation against such speculation. 3. Conclusion The paper has discussed and evaluated some important types of derivatives and the associated risks and the manner in which the risks can be managed were examined. In the case of OTC products, both parties are usually banks, hedge funds and financial institutions. In the case of ETD, unlike equity trade in the stock market, derivatives are forward contracts where two parties buy and sell the futures options based on estimated prices. Consequently, the amount of variation and fluctuation as seen in the equity market is not present. The presence of exchanges that serve as intermediaries also helps to protect risk from excessive variations. Investors can therefore use derivatives manage their risks. Hence, the risks of default are reduced. Returns obtained are lesser and they are available on long-term basis with at least six-month’s term. In any case, derivatives are not very free from risks and they can fail when there are severe and long-term disturbances in the market. 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